Spreading the risk. (Mutual Funds).

What do you do if you know nothing about stock market investing, have no desire to learn, but still want to invest? You could pin the stock market listings up, throw a dart, and buy the stock the missile hits. A better choice is to put your money into a mutual fund. This is how most individual investors now play the stock market. It allows small investors to follow the advice of all professionals, which is to diversify. This means buying a mixed bag of investments so that if there is a slump in one sector, the rest of your holdings will protect you. (Of course, if all sectors go into the tank nothing's going to save your nest egg.) So, a diversified portfolio might have some industrial stocks, bank shares, bonds, guaranteed investment certificates, and cash. The experts advise holding a slice of 15 to 20 different companies. Spreading the risk around different sectors might cost $100,000, if it's going to be done properly. Not everybody has that kind of money to invest. But, for $500 you can diversify just as effectively by putting money into a mutual fund. Your $500 is pooled with investments from other people. A mutual fund manager then invests those pooled resources into a variety of companies and financial instruments. So, you are buying a slice of a cake that contains a mixture of all its ingredients. On your own, you might only buy an egg that could break, or some milk that might go sour.

Not all funds are diversified. Many specialize in particular sectors. Bond funds only buy bonds. Gold funds only invest in gold bullion or gold mining companies. Science and technology funds ... well, you get the idea.

But, as with individual stocks, some mutual funds perform better than others. And, when the stock market as a whole goes down so do most of the mutual funds. Since early 2000 and through the spring of 2003, stock markets just about everywhere in the world have been in a funk. As a result, most mutual funds have been loosing value and Canadians have been dumping them.

When an investor takes money out of a mutual fund it's called a redemption. Mutual funds don't like this to happen, but they wouldn't have any customers if they didn't guarantee investors access to their cash on demand. Redemptions were hitting record highs in 2002; between July and November they totalled $4.4 billion. And, that creates a problem. Most mutual funds carry some cash on hand so they can buy stocks they think have good prospects. But, when big numbers of people redeem their investments they have to hand over this cash. If the redemptions continue, they have to sell stocks and bonds to generate cash. This pushes the market down further, prompting more people to redeem and so on.

Mutual fund companies don't manage other peoples' investments just because they're nice folks and want to help out. They charge fees in a couple of ways. "Loads" can be charged when the fund is purchased. This is called a front-end load and is a percentage of what is put into the fund. This can be as high as 8.5%. A back-end load might be charged when money is withdrawn from a fund; sometimes the percentage deducted goes down the longer the money is kept in the fund. Some funds advertise themselves as "No load." However, investors are still charged fees. These fees are called the management expense ratio (MERs) and you have to pay them whether the fund rises in value or falls. Win or lose, investors might expect to pay about 2.5% of the value of their investments each year in MERs.

Everybody wants the fund they've invested in to make them rich. In 2002, there were 1,963 mutual funds in Canada, only one of which was the top performer. Nine hundred and eighty funds were in the bottom half of performers. Avoiding putting your money into that bottom half requires some research. Every mutual fund company publishes glossy brochures explaining why their funds are better than everybody else's. The only guide investors have as to how well a fund will do is past performance. But, that's no guarantee of future performance. That hotshot fund manager who made spectacular profits in the past might be hired away by another fund company.

Fund managers feel extreme pressure to produce in the short term. Years ago, the brokers or investors would look at the financial position of a company and its potential for long-term growth. Today, most money managers and investors are looking at the short term. It almost doesn't matter what the stock is, just that at this moment it may be undervalued and if purchased now it can be sold for a profit a week later. This earns money for the mutual fund, but it does not contribute to the nation's economic growth. It is earnings on paper only.

Some of the best fund managers have moved into what are called hedge funds. A man called Alfred Winslow Jones started the first hedge fund in 1949, and he toiled away almost unnoticed for many years.

Mr. Jones developed two distinctive characteristics of the modern hedge fund: the idea that the fund manager's pay should be tied to how well the fund performs, and the fund's owner should put his or her own money into it. The pay-for-performance fee structure assured investors that the manager would stay sharp and focussed. Investing their own money said fund operators would only take risks with investor's money that they were prepared to take with their own.

Today, hedge funds represent one of the fastest growing segments of the investment world. During the past 10 years, the number of hedge funds has increased at an average rate of 25% to 27% a year. It is now estimated that there are 5,000 to 7,000 hedge funds globally with $400 to $500 billion under management.

But, there's a snag. You can't clean out the piggy bank and put its contents into a hedge fund. Most require a minimum investment of between $150,000 and $1 million and it has to be locked in to the fund for up to five years.

Investing in mutual funds still carries risk. However, because the mutual fund industry is regulated and watched over carefully, the chances of getting wiped out completely are low.

FACT FILE

In 2002, Canadians had $390 billion in mutual funds and there were 52.9 million accounts--almost two for every citizen.

Websites

Canadian Hedge Watch--http://www.canadianhedgewatch.com/default.asp

Investment Funds Institute of Canada--http://www.ific.ca/eng/home/index.asp

THE FUND OF FUNDS 

Bernie Cornfeld was a slick operator, but not quite slick enough. He was born in Turkey, grew up in the United States, and lived in Winnipeg for a while before moving to Geneva, Switzerland. In 1962, Mr. Cornfeld dreamed up the Fund of Funds. The idea was that his fund would invest in other mutual funds, only the best ones of course, and the little guy would become rich. There were 2,500 sales people around the world hustling the Fund of Funds, and they raised $4 billion (tens of billions in today's terms). Meanwhile, back in Geneva, Bernie Cornfeld and his pals were skimming stiff percentages in management fees. Eventually, the Fund of Funds collapsed and Bernie did 11 months in a Swiss prison. Several European and American banks failed, and thousands of small investors lost their life savings. It took years for the mutual fund industry to shake off the scandal. For many investors it never went away; they quit the mutual fund industry and the stock market for good.

PATIENCE AND PRUDENCE

Until the 1960s, most investors took a long-term view of the stock market. They put their money into a solid, stable company and left it alone. They were content to see their investment earn a modest dividend that would slowly build up to provide a retirement nest egg. This savings philosophy went back to the early 1800s when professional money managers first appeared. In those days, it was mostly lawyers or bankers who managed peoples' money. Investment management was mostly directed by the so-called "Prudent Man Rule." In essence, this meant that the manager sought a reasonable return but preserved capital and, most importantly, avoided speculation. Then, something called Modern Portfolio Theory (MPT) came along in the 1950s. This said that investors should diversify their holdings--some in utilities, a bit in banking, a few bonds, maybe a dabble in gold. Keeping track of these different investments needed some skill and knowledge--enter "The Prudent Expert Rule." People trained to manage Other Peoples' Money (OPM) started to hang out their shingles. Soon, The Prudent Experts were managing mutual funds.

Almost immediately, a cottage industry started up comparing the performance of mutual funds. Naturally, investors put their money where they were going to get the best return. So, the Prudent Experts got into a competition to make the most money, fastest. This competition continues today. Some of the experts have become Imprudent and have made risky investments because these carry the potential for higher rates of return. They also carry the risk of catastrophic losses.